Intermarket Analysis

Intermarket Analysis Most investors have something I like to call TVS, or 'Tunnel-Vision Syndrome'. They tend to focus on one market and absolutely analyze it to death. There scope is so narrow that they tend to miss the forest through the trees. The truth is that investors who focus on the bigger picture portrayed through ALL the markets tend to be the ones that deliver better performance.

There are four main asset classes we analyze in our investment universe; stocks, bonds, commodities and currencies. Traditional investors would have you believe there are only three, but we feel these four classes taken together create a very good picture of what's happening in the world.

According to John Murphy, author of Intermarket Analysis (a book I HIGHLY recommend), a truly diversified investment approach should include investments in four major asset classes: stocks, bonds, commodities and currencies. Further, intermarket analysis tells us that a diversified portfolio should not limit its dollars to one country, but include holdings in a number of markets around the world. By following multiple markets, an investor gets the big picture and is able to see significant market and economic changes earlier than investors with a single market focus. The multiple market investors can then move portfolio holdings from one sector or market to another with greater ease as conditions change. Finally, if you're investing dollars are focused in one area, say as an equity trader, the wisdom of intermarket analysis is not lost on you. Analyzing all four market as a whole can certainly help you discern the sectors you should be focused on and even whether or not to hold more or less cash.

An intermarket strategy means using market analysis, including both fundamental and technical analysis techniques, to determine and adjust your overall asset allocation according to changing market conditions. Let's take a look at how this rotational strategy may be applied by analyzing a few examples from past markets.

The Gold Stocks and the Dollar
As I mentioned above, an intermarket strategy means looking at differing asset classes and the relationships they share with each other and specific sectors. Take for instance the Dollar Index, Commodity Prices and the Gold sector, which together have confirmed high correlations. Our first chart below is a weekly chart that shows the inverse correlation between the US Dollar Index and the CRB Index (commodities) from 2002 to 2004. Typically, in an inflationary environment, a week dollar will translate to higher commodity prices. It stands to reason that a weak dollar makes American goods more affordable for foreign buyers. Also, the US is one of the most resource blessed countries in the world so a weak dollar tends to push most commodity prices higher.

Figure 1 - Weekly chart of the Hong Kong Hang Seng Index (lower window) and the Semiconductor Index (SOXX) showing strong correlation and Hang Seng leading the SOXX. Numbers 1 though 4 show buy (green) and sell (dark red) signals and the dates the signals were generated based on trend line breaks. Chart created with MetaStock.com

The Hang Seng gave a trend line break sell signal on October 17, 1997, about the same time as the trend line sell signal on the Philadelphia Semiconductor Index (see number 1). The fact that both indexes broke significant trend lines at the same time was a strong signal for exiting semiconductor holdings.

On October 2, 1998, the Hang Seng Index generated a buy signal, but the Semiconductor Index didn't emit a signal until the following week. This means that traders following only the Semiconductor Index, entering at 248, were one week behind those whose outlook included the Hang Seng Index, which gave its buy signal at 200 points (number 2).

It was the Hang Seng's next signal, however, that really gave its followers an edge. The Hang Seng broke a major trend line on April 4, 2000, when the SOXX was trading at 1150, giving a signal to semiconductor holdings. The Semiconductor Index, on the other hand, did not give a clear sell trend line break signal until six months later, on October 6, 2000, when the index was trading at 850. Traders using only the Semiconductor Index attained returns 26% below those traders following the Hang Seng (number 3).

The Hang Seng gave another earlier buy signal on June 6, 2003, (number 4), when the index was at 360. The Semiconductor Index, on the other hand, didn't emit its signal until more than two months later, when the index was trading 10% higher at 400.

Commodities and the Canadian Dollar Strategy
By broadening investing outlooks, intermarket analysis can also provide more opportunity for the investor or trader to protect his or her investments with an effective currency hedge. Quite simply, this means selling stocks or bonds denominated in weaker currencies and buying them in the strongest currencies wherever possible.

Both the Canadian and Australian dollars have, for example, demonstrated strong correlations to commodities. When commodity prices are strong, both do well. Since Canada is right next-door to the U.S. trader, he or she is able to buy and sell Canadian stocks or bonds with relative ease. See figure 2 for a chart that plots the relative strength of the Canadian dollar against the U.S. dollar.

Figure 2 - Daily chart of the Canadian dollar divided by the U.S. dollar. Note the long-term trend line break that occurred in April 2002 and the rapid increase in value of the Canadian dollar against the U.S. dollar in the next 18 months. In April, the Canadian dollar was trading at $0.63 USD. By December 2003 it was worth $0.77 USD, a 22% increase giving a significant advantage to portfolios that contained Canadian dollar based assets. Chart provided by MetaStock.com

Throughout the 1990s, the U.S. dollar was stronger than its northern counterpart, telling U.S. traders to steer clear of Canadian investments. However, those traders looking at the Commodity Research Bureau Index (CRB), which is composed of a basket of commodities, would have noticed when commodity prices began to rise, with the increase in the Canadian dollar. The CRB Index broke a medium-term down trend line in early 2002, which provided a commodity buy signal. In April 2002, the conditions of the 1990s changed. This was due to the fact that the U.S. dollar was weakening and commodity prices were gaining strength.

Here, major trend line breaks like those we saw in the semiconductor example determined when it was time to act. When the CAD/USD trend line was broken in early 2002 on the relative strength chart, those traders following it would have begun shifting their investments out of U.S. dollar denominated assets in favor of Canadian companies (see figure 2).

Other Advantages
Intermarket analysis can also teach us the important historic relationship between bonds, stocks and commodities in the business cycle. Bond prices generally lead stock prices in a recovery, with commodity prices confirming that a period of economic expansion has begun. As the expansion matures and begins to slow down, intermarket analysis teaches traders to watch for bonds to turn down first (as interest rates rise), followed by stocks. Finally, when commodity prices turn down, there is a pretty good chance that economic expansion has come to an end. The next phase is a slowdown and possible recession.

Looking at the past few years, we can see how an intermarket perspective can lend an advantage--in some cases a substantial one--over a single-market outlook. The intermarket trader watches markets in Asia and Europe, as well as the U.S., because what happens in one usually has an effect on the others (especially as globalization progresses). We have also seen how the intermarket analysis broadens the trader's use of currency strength to determine which national market offers the greatest safety for his or her investments.